Exam #1 Flashcards
Traditional Definition of Risk
Uncertainty concerning the occurrence of a loss
Physical Hazard
A physical condition that increases the frequency or severity of a loss
Moral Hazard
Dishonesty or character defects in a individual that increases the frequency or severity of loss
Attitudinal Hazard
Carelessness or indifference to a loss, which increases the frequency or severity of a loss
Legal Hazard
Characteristics of the legal system or regulatory environment that increase the frequency or severity of losses
Pure Risk
Situation in which there are only the possibilities of loss or no loss
Speculative Risk
A situation in which either profit or loss is possible
Diversifiable Risk
Affects only individuals or small groups. Can be reduced or eliminated by diversification
Non-diversifiable Risk
Affects entire economy or large number of people or groups within the economy. Also called fundamental risk
Direct Loss
A financial loss that results from the physical damage, destruction, or theft of the property, such as fire damage to a home
Indirect Loss
A financial loss that results indirectly from the occurrence of a direct physical damage or theft loss
Insurance
Pooling of fortuitous losses by transfer of such risk to insurers, who agree to indemnify insureds for such losses, to provide pecuniary benefits on their occurrence, or to render services connected with the risk
Pooling
Spreading of losses incurred by the few over the entire group, so that in the process, the average loss is substituted for the actual loss
Fortuitous Losses
Unforeseen and unexpected circumstances that occur by chance
Risk Transfer
When the risk is passed on to the insurance company
Indemnification
Insured is restored to pre-loss financial position
Law of Large Numbers
The larger the number of similar exposure units considered, the more closely the losses reported will equal the underlying probability of loss - expected loss does not change, but SD does
Six Characteristics of an Ideally Insurable Risk
- Large Number of Exposures
- Accidental and Unintentional Loss
- Determinable and Measurable Loss
- No Catastrophic Loss
- Calculable Chance of Loss
- Economically Feasible Premium
Large Number of Exposures
Predict average loss based on the law of large numbers
Accidental and Unintentional Loss
To assure random occurrence of events
Determinable and Measurable Loss
To determine how much should be paid
No Catastrophic Loss
The pooling technique works this way when the loss is not too large to bare
Calculable Chance of Loss
To establish a premium that is sufficient to pay all claims and expenses and yields a profit during the policy period
Economically Feasible Premium
People need to afford purchasing the insurance policy so the premiums paid must be substantially less than the face value, or amount, of the policy
Risk Management
A process that identifies loss exposures faced by an organization and selects the most appropriate techniques for treating such exposures
Pre-Loss Objectives
Prepare for potential losses in the most economical way to reduce anxiety and meet legal obligations
Post-Loss Objectives
- Survival of the Firm
- Continue Operating
- Stability of Earnings
- Continued Growth of the Firm
- Minimize the effects that a loss will have on other people and society
Traditional Risk Management Process
- Identify
- Measure and Analyze
- Select
- Implement and Monitor
Identify Loss Exposures
Key risks and potential losses like property, liability, and businesses
Measure and Analyze
Evaluating frequency and severity of losses
Select
Choosing risk management technique or combination of techniques
Implement and Monitor
Put selected methods in place and measure performance
Loss Frequency
The probable number of losses that may occur during some time period
Loss Severity
Probable size of losses that may occur. This is more important
Risk Control Techniques
- Avoidance
- Loss Prevention
- Loss Reduction
- Duplication
- Separation
- Diversification
Avoidance
A certain loss exposure is never acquired or undertaken, or an existing loss exposure is abandoned
Loss Prevention
Measures that reduce the frequency of a particular loss
Loss Reduction
Measures that reduce the severity of a loss after it occurs
Duplication
Having back-ups or copies of important documents or property available in case a loss occurs
Separation
Dividing the assets exposed to loss to minimize the harm from a single event
Diversification
Spreading the loss exposure across different parties, securities, or transactions, to reduce the chance of loss
Risk Financing
Techniques that provide for the payment of losses after they occur
Retention
Firm retains part or all of the losses that can result from a given loss
Captive Insurers
Owned entity set up for more efficient retention/self-payment of losses
Non-insurance Transfers
Pure risk and its potential financial consequences are transferred to another party
Commercial Insurance
Insurance for low probability and high-severity loss exposures
Enterprise Risk Management
Comprehensive risk management program that addresses all risks faced by the organization. Managed by a CRO to prevent the “silo” effect. Considers internal and external environments. Establishes risk appetite and risk tolerance.
Risk Appetite
Total exposure an organization is willing to accept, give the risk and return trade-off
Risk Tolerance
Amount of uncertainty that and organization is willing to accept
Types of Private Insurers
- Stock Insurers
- Mutual Insurers
- Lloyd’s of London
- Reciprocal Exchanges
- Blue Cross
- Managed Care Plans
- Captive Insurance Companies
Stock Insurer
Corporation owned by stockholders. They earn profit for stockholders by increasing the value of stock and paying dividends. Capital can be raised by selling more shares of stock
Mutual Insurer
Corporation owned entirely by policyholders. Cannot raise capital by selling more shares of stock
Lloyd’s of London
Not an insurer, but a society of members who underwrite insurance in syndicates
Reciprocal Exchange
Unincorperated organization in which insurance is exchanged among the members
Blue Cross and Blue Shields Plan
Nonprofit community-oriented plans
Managed Care Plan
Comprehensive healthcare services to members
Captive Insurance Companies
An insurer owned by a parent for a specific purpose.
Characteristics of Stock Insurers
- Elect board of directors who appoint executive leaders who run the company’s day-to-day operations
- Bear all losses up to the level of investment but have limited liability
Characteristics of Mutual Insurers
- Policy owners elect board of directors, who have effective management
- If company has excess profits, dividends paid to policyowners
- Policyholders usually have limited liability; they cannot be assessed for excess loss
Demutualization
Mutual company converted to a stock insurer
Pros of Demutualization
- Easier to raise capital
- Greater flexibility in some regards, such as being able to offer employee stock options
Cons of Demutualization
- Increasing SEC reporting requirements
- Management may receive a large proportion of stock relative to policyholders
Examples of Managed Care Plans
- Healthcare Maintenance Organizations (HMO)
- Point of Service Plan (POS)
- Preferred Provider Organization (PPO)
Agents
Someone who legally represents the principal and has the authority to act on the principal’s behalf. P&C agents can bind company but life agents can’t
Broker
Someone who legally represents the insured. They solicits applications and attempts to place coverage with an appropriate insurer
- Paid a commission from the insurers where the business is placed
- Does not have the authority to bind the insurer
Typical Functions of an Insurance Company
- Ratemaking
- Marketing/Production
- Underwriting
- Investments
- Claim Settlement
- Reinsurance
Ratemaking
Pricing of insurance and the calculation of insurance premiums. Actuaries determine the rates, and need to provide for adverse deviation
Underwriting
Process of selecting, classifying, and pricing applicants for insurance. Protect from adverse selection
Premium
Rate * Exposure Units
Adverse Selection
Tendency of people with a higher-than-average chance of loss to seek insurance at standard rates. If not controlled by underwriting, this will result in higher-than expected loss levels
Retrocession
When a reinsurer insures part or all of a risk with another insurer
Pro-rata vs. Excess Coverage
One agrees to share losses and premiums based on some proportion while the other pays only when covered losses exceed a certain level
Facultative Reinsurance
Case-by-case method in which a ceding company receives an application for insurance that exceeds its retention limit. It is often used when the primary insurer has an application for a large amount of insurance
Treaty Reinsurance
Primary insurer has agreed to cede insurance to reinsurer, and the reinsurer has agreed to accept the business. All business that fails within the scope of the agreement is automatically reinsured according to the terms of the treaty
